Micro_Chapter7.pdf

CHAPTER 7 Consumer Choice and Utility Maximization PowerPoint Presentation Prepared by: Jason Dean, King’s University College © 2022 McGraw Hill Ltd. LEARNING OBJECTIVES LO7.1 Define and explain total utility, marginal utility, and the law of dim...

CHAPTER 7 Consumer Choice and Utility Maximization PowerPoint Presentation Prepared by: Jason Dean, King’s University College © 2022 McGraw Hill Ltd. LEARNING OBJECTIVES LO7.1 Define and explain total utility, marginal utility, and the law of diminishing marginal utility. LO7.2 Describe how rational consumers maximize utility. LO7.3 Explain how to derive the demand curve by observing the outcomes of price changes. LO7.4 Discuss how the utility-maximization model highlights the income and substitution effects of a price change. LO7.5 Apply the theory of consumer choice to real-world phenomena. © 2022 McGraw Hill Ltd. 2 7.1 THE LAW OF DIMINISHING MARGINAL UTILITY THE LAW OF DIMINISHING MARGINAL UTILITY: – Is the principle that added satisfaction declines as a consumer acquires additional units of a given product – Terminology – Utility is want-satisfying power – Total Utility and Marginal Utility – Total utility: total amount of satisfaction – Marginal utility: extra satisfaction from consuming one more unit © 2022 McGraw Hill Ltd. 3 FIGURE 7.1 TOTAL AND MARGINAL UTILITY Total Utility 30 (1) (2) (3) Total Utility (Utils) Tacos Total Marginal Consumed Utility, Utility, 20 Per Meal Utils Utils 0 0 10 1 10 2 18 0 1 2 3 4 5 6 7 3 24 4 28 Marginal Utility (Utils) 5 30 10 8 6 30 6 7 28 4 2 0 -2 1 2 3 4 5 6 7 MU © 2022 McGraw Hill Ltd. 4 FIGURE 7.1 TOTAL AND MARGINAL UTILITY 30 (1) (2) (3) Total Utility (Utils) Tacos Total Marginal Consumed Utility, Utility, 20 Per Meal Utils Utils 0 0 10 1 10 2 18 0 1 2 3 4 5 6 7 3 24 4 28 Marginal Utility (Utils) 5 30 10 8 6 30 6 7 28 4 2 0 -2 1 2 3 4 5 6 7 MU © 2022 McGraw Hill Ltd. 5 FIGURE 7.1 TOTAL AND MARGINAL UTILITY Total Utility 30 (1) (2) (3) Total Utility (Utils) Tacos Total Marginal Consumed Utility, Utility, 20 Per Meal Utils Utils 0 0 10 1 10 2 18 0 1 2 3 4 5 6 7 3 24 4 28 Marginal Utility (Utils) 5 30 10 8 6 30 6 7 28 4 2 0 -2 1 2 3 4 5 6 7 MU © 2022 McGraw Hill Ltd. 6 FIGURE 7.1 TOTAL AND MARGINAL UTILITY 30 (1) (2) (3) TU Total Utility (Utils) Tacos Total Marginal Consumed Utility, Utility, 20 Per Meal Utils Utils 0 0 10 1 10 2 18 0 1 2 3 4 5 6 7 3 24 4 28 Marginal Utility (Utils) 5 30 10 8 6 30 6 7 28 4 2 0 -2 1 2 3 4 5 6 7 MU © 2022 McGraw Hill Ltd. 7 FIGURE 7.1 TOTAL AND MARGINAL UTILITY Total Utility 30 (1) (2) (3) TU Total Utility (Utils) Tacos Total Marginal Consumed Utility, Utility, 20 Per Meal Utils Utils 0 0 10 ] 10 1 10 ] 8 2 18 3 24 ] 6 0 1 2 3 4 5 6 7 4 28 ] 4 Marginal Utility (Utils) 5 30 ] 2 10 6 30 ] 0 8 6 7 28 ] -2 4 2 0 -2 1 2 3 4 5 6 7 MU © 2022 McGraw Hill Ltd. 8 FIGURE 7.1 TOTAL AND MARGINAL UTILITY Total Utility 30 (1) (2) (3) TU Total Utility (Utils) Tacos Total Marginal Consumed Utility, Utility, 20 Per Meal Utils Utils 0 0 10 ] 10 1 10 ] 8 2 18 3 24 ] 6 0 1 2 3 4 5 6 7 4 28 ] 4 Marginal Utility (Utils) 5 30 ] 2 10 6 30 ] 0 8 6 7 28 ] -2 4 2 0 -2 1 2 3 4 5 6 7 MU © 2022 McGraw Hill Ltd. 9 7.1 THE LAW OF DIMINISHING MARGINAL UTILITY MARGINAL UTILITY AND DEMAND Diminishing marginal utility provides a simple rationale for the law of demand. – Since successive units of a good yield smaller and smaller amounts of marginal utility, – The consumer will buy additional units of a product only if its price falls. © 2022 McGraw Hill Ltd. 10 7.2 THE THEORY OF CONSUMER CHOICE CONSUMER CHOICE AND THE BUDGET CONSTRAINT We assume a typical consumer: – Exhibits rational behaviour – Has clear-cut preferences – Is subject to a budget constraint – Responds to price changes © 2022 McGraw Hill Ltd. 11 7.2 THE THEORY OF CONSUMER CHOICE UTILITY-MAXIMIZING RULE – The consumer’s money income should be allocated so that the last dollar spent on each product purchased yields the same amount of extra (marginal) utility. – Algebraically: © 2022 McGraw Hill Ltd. 12 7.2 THE THEORY OF CONSUMER CHOICE UTILITY-MAXIMIZING RULE – The consumer’s money income should be allocated so that the last dollar spent on each product purchased yields the same amount of extra (marginal) utility. – Algebraically: MU of product A MU of product B = Price of A Price of B © 2022 McGraw Hill Ltd. 13 TABLE 7.1 THE UTILITY-MAXIMIZING COMBINATIONS OF APPLES AND ORANGES (1) (2) (3) Unit of Apple (Product A): Oranges (Product B): Product Price = $1 Price = $2 (b) (b) Marginal (a) Marginal (a) Utility per Marginal Utility per Marginal Utility, dollar Utility, dollar Utils (MU/Price) Utils (MU/Price) First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 6 16 8 Fifth 5 5 12 6 Sixth 4 4 6 3 Seventh 3 3 4 2 © 2022 McGraw Hill Ltd. 14 TABLE 7.1 THE UTILITY-MAXIMIZING COMBINATIONS OF APPLES AND ORANGES (1) (2) (3) Unit of Apple (Product A): Oranges (Product B): Product Price = $1 Price = $2 (b) (b) Marginal (a) Marginal (a) Utility per Marginal Utility per Marginal Utility, dollar Utility, dollar Utils (MU/Price) Utils (MU/Price) First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 6 16 8 Fifth 5 5 12 6 Sixth 4 4 6 3 Seventh 3 3 4 2 © 2022 McGraw Hill Ltd. 15 TABLE 7.1 THE UTILITY-MAXIMIZING COMBINATIONS OF APPLES AND ORANGES (1) (2) (3) Unit of Apple (Product A): Oranges (Product B): Product Price = $1 Price = $2 (b) (b) Marginal (a) Marginal (a) Utility per Marginal Utility per Marginal Utility, dollar Utility, dollar Utils (MU/Price) Utils (MU/Price) First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 6 16 8 Fifth 5 5 12 6 Sixth 4 4 6 3 Seventh 3 3 4 2 © 2022 McGraw Hill Ltd. 16 TABLE 7.1 THE UTILITY-MAXIMIZING COMBINATIONS OF APPLES AND ORANGES (1) (2) (3) Unit of Apple (Product A): Oranges (Product B): Product Price = $1 Price = $2 (b) (b) Marginal (a) Marginal (a) Utility per Marginal Utility per Marginal Utility, dollar Utility, dollar Utils (MU/Price) Utils (MU/Price) First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 6 16 8 Fifth 5 5 12 6 Sixth 4 4 6 3 Seventh 3 3 4 2 © 2022 McGraw Hill Ltd. 17 TABLE 7.1 THE UTILITY-MAXIMIZING COMBINATIONS OF APPLES AND ORANGES (1) (2) (3) Unit of Apple (Product A): Oranges (Product B): Product Price = $1 Price = $2 (b) (b) Marginal (a) Marginal (a) Utility per Marginal Utility per Marginal Utility, dollar Utility, dollar Utils (MU/Price) Utils (MU/Price) First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 6 16 8 Fifth 5 5 12 6 Sixth 4 4 6 3 Seventh 3 3 4 2 © 2022 McGraw Hill Ltd. 18 TABLE 7.1 THE UTILITY-MAXIMIZING COMBINATIONS OF APPLES AND ORANGES (1) (2) (3) Unit of Apple (Product A): Oranges (Product B): Product Price = $1 Price = $2 (b) (b) The utility- Marginal (a) Marginal maximizing (a) Utility per Marginal Utility per combination of Marginal Utility, dollar Utility, dollar goods Utils (MU/Price) Utils (MU/Price) attainable by First 10 10 24 12 Holly is Second 8 8 20 10 therefore 2 apples and 4 Third 7 7 18 9 oranges. Fourth 6 6 16 8 Fifth 5 5 12 6 Sixth 4 4 6 3 Seventh 3 3 4 2 © 2022 McGraw Hill Ltd. 19 TABLE 7.2 SEQUENCE OF PURCHASES TO ACHIEVE CONSUMER EQUILIBRIUM Choice Potential Marginal Utility Purchase Income Number Choices per Dollar Decision Remaining First Apple 10 First orange for 1 $8 = $10 - $2 First Orange 12 $2 First apple for $1 First Apple 10 2 and Second $5 = $8 -$3 Second Orange 10 orange for $2 Second Apple 8 Third orange for 3 $3 = $5 - $2 Third Orange 9 $2 Second apple for Second Apple 8 $1 4 $0 = $3 - $3 Fourth Orange 8 and Fourth orange for $2 © 2022 McGraw Hill Ltd. 20 7.2 THE THEORY OF CONSUMER CHOICE UTILITY MAXIMIZATION – At each step, spend where MU/$ is highest – In general, if MU/$ is unequal, spending should be allocated: – Away from the good where MU/$ is low – Toward the good where MU/$ is high © 2022 McGraw Hill Ltd. 21 7.3 UTILITY MAXIMIZATION AND THE DEMAND CURVE DERIVING THE DEMAND SCHEDULE AND CURVE – The utility-maximizing rule makes it easy to see why price and quantity are inversely related. – We can derive a consumer’s demand schedule by considering alternative prices and then determining the corresponding quantity demanded of the consumer. – The determinants of an individual’s demand (preferences, income and price of related goods) are reflected in Table 7-1. – Example: given tastes, income, and the prices of other goods, the consumer will purchase four oranges when the price $2. © 2022 McGraw Hill Ltd. 22 7.3 UTILITY MAXIMIZATION AND THE DEMAND CURVE Let’s assume the price of oranges falls to $1 Unit of product Apples (product A) P=$1 Oranges (product B) P= $1 Marginal utility MU/p Marginal utility MU/p 1st 10 10 24 2nd 8 8 20 3rd 7 7 18 4th 6 6 16 5th 5 5 12 6th 4 4 6 7th 3 3 4 © 2022 McGraw Hill Ltd. 23 7.3 UTILITY MAXIMIZATION AND THE DEMAND CURVE Let’s assume the price of oranges falls to $1 Unit of product Apples (product A) P=$1 Oranges (product B) P= $1 Marginal utility MU/p Marginal utility MU/p 1st 10 10 24 24 2nd 8 8 20 20 3rd 7 7 18 18 4th 6 6 16 16 5th 5 5 12 12 6th 4 4 6 6 7th 3 3 4 4 © 2022 McGraw Hill Ltd. 24 7.3 UTILITY MAXIMIZATION AND THE DEMAND CURVE Let’s assume the price of oranges falls to $1 Unit of product Apples (product A) P=$1 Oranges (product B) P= $1 Marginal utility MU/p Marginal utility MU/p 1st 10 10 24 24 2nd 8 8 20 20 3rd 7 7 18 18 4th 6 6 16 16 5th 5 5 12 12 6th 4 4 6 6 7th 3 3 4 4 © 2022 McGraw Hill Ltd. 25 FIGURE 7.1 DERIVING AN INDIVIDUAL DEMAND CURVE Price per unit of Quantity demanded oranges $2 Price of Orange $1 0 4 6 Quantity Demanded of Oranges © 2022 McGraw Hill Ltd. 26 FIGURE 7.1 DERIVING AN INDIVIDUAL DEMAND CURVE Price per unit of Quantity oranges demanded $2 2 4 Price of Orange The consumer represented by the data in the table maximizes utility by purchasing 4 oranges $1 at a price of $2. 0 4 6 Quantity Demanded of Oranges © 2022 McGraw Hill Ltd. 27 FIGURE 7.1 DERIVING AN INDIVIDUAL DEMAND CURVE Price per unit of Quantity oranges demanded $2 2 4 1 6 Price of Orange The decline in the price of oranges to $1 disrupts the consumer’s initial utility- $1 maximizing equilibrium. The consumer restores equilibrium by purchasing 6 rather than 4 oranges. 0 4 6 Quantity Demanded of Oranges © 2022 McGraw Hill Ltd. 28 FIGURE 7.1 DERIVING AN INDIVIDUAL DEMAND CURVE Price per unit of Quantity oranges demanded $2 2 4 1 6 Price of Orange Thus, a simple price–quantity schedule emerges, which locates two points on a downward- $1 sloping demand curve. DO 0 4 6 Quantity Demanded of Oranges © 2022 McGraw Hill Ltd. 29 7.4 INCOME AND SUBSTITUTION EFFECTS SUBSTITUTION EFFECT – The impact that a change in a product’s price has on its relative expensiveness and consequently on the quantity demanded. – When the price of oranges fall, there is a substitution of now less expensive oranges © 2022 McGraw Hill Ltd. 30 7.4 INCOME AND SUBSTITUTION EFFECTS INCOME EFFECT – The impact that a change in the price of a product has on a consumer’s real income and consequently on the quantity demanded of that good. – Increase in real income increases consumption of both apples and oranges © 2022 McGraw Hill Ltd. 31 7.4 INCOME AND SUBSTITUTION EFFECTS INCOME EFFECT – The impact that a change in the price of a product has on a consumer’s real income and consequently on the quantity demanded of that good. – Increase in real income increases consumption of both apples and oranges Both effects help explain why a demand curve is downward sloping. © 2022 McGraw Hill Ltd. 32 7.5 APPLICATIONS AND EXTENSIONS Many real-world phenomena can be explained by applying the theory of consumer choice. – NEW PRODUCTS – iPads – iPads must have had a higher MU/P than for alternative products when it was introduced. – DIAMOND-WATER PARADOX – Why would water, essential to life, be priced below diamonds, which have much less usefulness? © 2022 McGraw Hill Ltd. 33 EXERCISE: UTILITY MAXIMIZATION INCOME = $11 BURGER (Price=$2) SHAKE (Price=$1) QUANTITY MU MU/P MU MU/P 1 90 50 2 80 40 3 70 30 4 60 20 5 50 15 6 40 10 1) Fill out the column MU/P for both Burger and Shake 2) Identify all the bundles that satisfy MU per $ for Burger = MU per $ for Shake 3) Identify the OPTIMAL bundle 4) Calculate the maximized total utility (TU) for the optimal bundle © 2022 McGraw Hill Ltd. 34 CHAPTER SUMMARY LO7.1 Define and explain total utility, marginal utility, and the law of diminishing marginal utility. LO7.2 Describe how rational consumers maximize utility. LO7.3 Explain how to derive the demand curve by observing the outcomes of price changes. LO7.4 Discuss how the utility-maximization model highlights the income and substitution effects of a price change. LO7.5 Apply the theory of consumer choice to real-world phenomena. © 2022 McGraw Hill Ltd. 35